OBTAINING A SMALL BUSINESS LOAN
Henry Wichmann, University of Alaska, Anchorage Donald Reid, U.S. Small Business Administration ABSTRACT The primary purpose of this article is to serve as a basic guide for the small business person who may be thinking of applying for a bank loan either with or without an SBA guarantee. This article explains loan packaging requirements for small business borrowers. After receiving a well packaged loan, the loan officers look at feasibility criteria, such as management ability, earnings potential, equity ratio, and collateral to determine whether or not the loan is workable. INTRODUCTION The Small Business Administration (SBA) provides financial, management, and procurement assistance to existing and new businesses. The small business person starting a new business is first concerned with obtaining financing. Later, after the business is started, these entrepreneurs may find management and procurement help is needed to keep the business alive and profitable. The primary purpose of this article is to serve as a basic guide for the small business person who may be thinking of applying for a bank loan either with or without an SBA guarantee. Doing the Homework The loan applicant must first do his homework. At a minimum, the person or persons either starting, purchasing or improving a small business should compile at least the following information: First, general information about the business. This written narrative should include such information as the type of business, its legal organization, a brief history, the location, the competition, the availability of supplies, and a description of the customer to be served. Second, information should be drawn about the management of the business. Personal resumes should be written showing the abilities of the owners and key personnel. Personal financial statements of principal owners must also be prepared, as well as copies of recent Federal income tax returns. Third, background information should be developed to include the amount and purpose of the loan. Values of personal and business collateral offered to secure the loan should be ascertained with independent appraisals where appropriate. Finally, certain business information should be given on the new or existing business. For new businesses, a projected income statement must be prepared listing monthly projections of earnings for the first year the business will operate. The loan applicants should list sources of funds they supply and the amount to be financed with the loan. When applicable, life and casualty insurance contracts, lease agreements, and licenses and permits needed should be listed in either a new business or existing business loan application. Existing businesses must provide an income statement for the previous two years and the current year to within 90 days of the application date. In addition, a current balance sheet is required for existing businesses. Business acquisitions (buyouts) require the same loan information as existing businesses. The above loan application information is needed for either a conventional bank loan or an SBA guaranteed bank loan. SBA guaranteed loans require certain government forms be completed including SBA Form 4, Application for a Loan; SBA Form 1251,
Statement of Federal Laws and Executive Orders; and SBA Form 912, Statement of Personal History. The above forms are filled out and/or acknowledged by the borrower, not the lender. Feasibility Criteria The loan applicant should realize processing time is considerably reduced if he is well prepared before approaching the bank. After the prospective borrower has gathered the necessary background information and completed application forms, the loan officers analyze the entire package. The following feasibility criteria are generally used in deciding whether or not to grant or refuse the loan: 1. Management ability. Does the borrower have experience in the business and know how to run (manage) it? 2. Earnings ability. Does the borrower have the ability to repay the loan? This criteria is based on the borrowers character, his debt paying record, past earnings of the business, and future prospects of the business. 3. Financial condition. What is the financial condition of the borrower's business, based on the ratio of debt to net worth (equity). SBA cannot make a loan to a business with negative net worth (deficit). 4. Collateral. What is the value and condition of the borrowers' collateral offered to secure the loan. The SBA will not refuse a loan on the sole grounds of inadequate collateral. If the loan application is workable, the prospective small business borrower will obtain the necessary funds. If one of the feasibility criteria is not present, the loan may still be workable. Usually, when management is weak, earnings are weak and when equity is weak, collateral is weak. Management and earnings are the keys; if these two criteria are strong, the loan can usually be made. The prospective borrower should expect to risk a reasonable amount of funds for financing the new or existing business. Eligibility Criteria The eligibility criteria start with "what is a small business?" These eligibility criteria pertain to SBA guaranteed bank loans and SBA direct loans, not to conventional bank loans. The Small Business Act defines a small business as a concern that is "independently owned and operated and which is not dominant is its field of operation." It is further defined by the number of employees and/or dollar volume of business. The size standards for small business include approximately 97% of all businesses within the United States. (Because Alaska and Hawaii have a higher cost of doing business than other states, the dollar standards are even larger.) Examples of standards for some of the predominant businesses are as follows: Retail or Service - any retail or service business whose annual sales or receipts do not exceed $2,000,000.00 (Alaska/Hawaii $2,666,666.00). Wholesale - any wholesaler whose annual sales do not exceed $10,000,000.00 (Alaska/Hawaii $12,635,000.00). Construction - any construction concern whose annual sales or receipts do not exceed $10,000,000.00 (Alaska/Hawaii $12,635,000.00) averaged for three preceding fiscal years. Manufacturing - any manufacturing concern is classified as small if its number of employees does not exceed 250 or 1,000 employees, depending upon industry.
Farming - any agricultural concern is classified as small if its average annual receipts for its preceding three fiscal years do not exceed $1 million. Others - separate size standards exist for mining, livestock feeding, communication, shopping centers, etc., if in doubt, call the SBA. The remaining eligibility criteria are primarily based on the nature of the business or the intended use of the funds from the loan. The loan applicant ordinarily should be legally organized as a "profit" enterprise as opposed to "non profit." It should be properly licensed by the appropriate state or local authority. The funds should not encourage monopoly, speculation, gambling, or multilevel sales distribution plans. Generally, the SBA guaranteed loan must be in the public interest and not infringe upon peoples rights. Some specific areas of ineligibility include: 1. Concerns primarily engaged in businesses involving ideas, values, thoughts, opinions or similar intellectual property except where they come under other regulatory jurisdiction, i.e. publishing, motion pictures, schools, etc. 2. Concerns primarily engaged in lending or investments. 3. Private, as apposed to being open to the general public such as recreational or amusement enterprises. 4. The SBA may not make or guarantee loans for investment or speculative purposes. SBA's definition of investment prohibits loans to finance the construction, acquisition, conversion or maintenance or any real or personal property held by the owner for the primary purpose of producing income. However, "alter ego" situations may be financed by an SBA guaranteed bank loan. Many times, for tax or accounting purposes, small business owners may form two legal entities, one which owns the property and leases it directly to the other. The SBA will approve a loan when the property is to be leased in its entirety to an eligible small business concern, provided the ownership of the small business and the property are identical, and the lease is for the term of the loan. A prospective borrower should first approach the local banks for the loan. If the bank refuses to loan money on reasonable terms, then the bank can be asked to participate with the SBA. If the bank still refuses, then the borrower should approach the SBA for a possible direct government loan. The SBA direct loan program has been severely curtailed, making the SBA-bank guaranty type participation loan the most popular loan program. Under the quaranteed loan program, a qualified lender makes the loan and concurrently applies to SBA for a guarantee of the loan. The SBA guarantee is limited to the lessor of 90% of the loan or $500,000.00. Therefore, if a business requires greater than $555,000.00 the maximum amount of the loan that SBA could guarantee would be limited to $500,000.00. The bank may turn sell the guaranteed portion (90 percent) to a secondary loan market. The secondary market provides the banks with liquidity and funds to loan again to more borrowers. The Alaska Industrial Development Authority (AIDA) is a commonly used secondary market in Alaska for SBA-bank quaranty type loans. Many secondary loan markets exist nationwide, some government sponsored like the Alaska AIDA fund. However, most secondary markets are independently qualified funds. The Alaska Industrial Development Authority is the principal reason Alaska SBA loans soared in numbers the last few years to where better than 20 percent of the commercial loans in Alaska are sponsored by SBA guarantee. The loan term is negotiated with the bank, however, SBA has certain limits on its guarantee. The maximum is 25 years, but that is usually reserved for loans secured by real estate with lesser terms guaged to the purpose of the loan.
The interest rate is also negotiated with the bank subject to SBA's limits. The present limits are pegged to the prime rate and SBA allows for the interest rate to be no more than 2 1/4% over prime for loans of less than 7 years. The interest rate may either be fixed for the term of the loan or variable with periodic adjustments as frequently as quarterly. Normally conventional bank loans are for shorter terms and/or higher interest rates than those that are quaranteed by SBA. CONCLUSION Financing a new or existing business may be accomplished through commercial bank regular channels, SBA guaranteed loans, SBA direct loans, private individuals, state development companies and many other sources. This article explained loan packaging requirements for borrowers applying for bank loan either with or without an SBA guarantee. Prior to approaching a bank or SBA loan officer, a prospective borrower should prepare the needed background information for obtaining the loan. The loan officers then determine whether the loan is workable by using management ability, earnings ability, equity ratio, and collateral as criteria to judge whether or not the borrower should receive the loan.